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Video: Should I Harvest Capital Gains?

Video: Should I Harvest Capital Gains?

March 15, 2024

Transcript:

Hey, guys. Mike Frontera here with Retirement Theory. And today we're talking about capital gains. But first a caveat, this is intended to be educational only, not specific tax and legal advice. For advice concerning your own situation, be sure to consult the appropriate professional advisor.

 

  1. First, when we're talking about capital gains, we will have to first define what is a capital asset. Well, according to the IRS, a capital asset is basically everything you own or use for personal or investment purposes.

 

Typically, when we're talking about capital gains, we're talking about investments that are within maybe a brokerage account or a mutual fund account or basically some place that is not in a retirement account like an IRA or a 401K. Real estate would also qualify as a capital asset, so real estate investments or even your own home. Or collectables. Also capital assets.

 

Keep in mind that both real estate and collectibles have their own complications with capital gains rates. So really for today we're focusing in on your typical investment accounts that are subject to normal either short-term or long-term capital gains.

 

For today, I want to specifically focus on long-term capital gains. So that is when you hold a capital asset for one year or more. Short-term

capital gains, generally speaking, will follow the ordinary income tax rates.

 

So we're looking at these special long-term capital gains tax brackets and I'll pull them up on the screen here.  There are primarily three different tax brackets.

 

You've got, and this is my favorite one, the 0% tax bracket and that you’re not paying a dime in taxes. When you go to sell an asset that's grown, you are in a 0% tax bracket for federal purposes. State is different. For federal purposes, up to $94,000 of income $90,450. We then got the 15% tax bracket, which is huge, covers a huge swath of income. And then a 20% tax bracket on top of that.

 

The other part that you need to be aware of is this 3.8% net investment tax. So this actually lumps on top of your capital gains if you exceed any of these thresholds. So basically $200,000 as a single filer or $250,000 as a married filing jointly.

 

So now the point of this video is harvesting capital gains, OK.

 

And you've probably heard of the term tax loss harvesting. You are selling assets that have gone down in value, with the purpose being to either pick up a small tax deduction, you can deduct up to $3000 of ordinary income from a capital loss, or offset other gains you may have this in that year.

 

One thing that you have to be aware of when you do that, if you are going to sell, let's say an S&P 500 fund. You cannot buy a substantially similar S&P 500 fund. Or if you buy individual stock, say an ExxonMobil stock, you cannot rebuy that stock or a substantially similar investment within 30 days. Otherwise, you run afoul of what are called the wash sale rules and your capital loss can be disallowed.

 

When you harvest capital gains, there is no wash sale rule. So, you had a gain in Tesla stock and you wanted to harvest that for this year, you could sell that stock and then immediately repurchase that stock and there is no problem there. Makes sense. The IRS is cool with you saying, “OK, I'll pay the tax on this money now rather than let it defer and rebuy the same stock or investment.” They're not as worried about that.

 

So then how does this tax loss harvesting work? What is the point of doing it?

When we're harvesting capital gains here, we're actually looking at it much in the same way as we look at Roth conversions. That is, we're trying to realize income while it's cheap in order to avoid having to realize it later at a more expensive rate.

 

So going back to those capital gains tax brackets, if we could harvest a bunch of capital gains in this 0% rate, might that make sense to reestablish a cost basis at a higher level and pay nothing in federal tax to do it?

 

So then what you could do if you've got a highly appreciated asset, let's just say that you've got some that you have a $30,000 unrealized capital gain, and you have $30,000 left within your 0% capital gains bracket. Well, in theory, you could sell that Tesla immediately. Rebuy it realizing that $30,000 capital gain, pay no federal tax on it, and now your cost basis is $30,000 higher than it was before.

 

So let's take a look at an example with our old pals, Jerry and Ginny and see how the capital gains harvesting could actually work in practice.

 

You know our old pals, Jerry and Ginny. So, in this scenario, Jerry and Ginny are each taking $4000 per month from their IRAs. So that is a total of $48,000 each or $96,000 of income. They have no other income sources.

 

Just to kind of keep it simple, they have $32,000 in deductions and actually all of that. I'll zoom in a little. Actually, all of that is just their standard deduction this year. They're both over 65. So that brings their taxable income down to $63,700 and their total tax of $7,180, so keep that number in mind.

 

You can see they're in the 12% tax bracket. These are your ordinary income tax rate. So now looking at the capital gains, you'll see that the threshold to go to that 15% tax bracket is actually remarkably similar to the end of the 12% tax rate. So basically, again, we're still about $30,000 under or still within the 0% tax rate for capital gains and again with capital gains that stacks on top of the ordinary income rates. So meaning if I had $1,000,000 of capital gains, we would still actually being the 12% tax rate here for ordinary income or so.

 

Higher capital gains does not impact your ordinary income tax rate. OK, again, let's look at their total tax is $7,180 on $96,000 of income. Now we're going to have them realize $30,000 in long term capital gains. This again this will allow if they buy the same stock or fund right back, this will push up their cost basis by that $30,000.

 

So in this scenario now. Our total income is $126,000 because of those extra $30,000 capital gains. And look, their total tax has not changed. It is still $7,180. You'll see we are at $93,700 including those capital gains. So we are just under the threshold of where we would pay 15%.

Keep in mind that capital gains tax stacks on top of ordinary income. So a lot of times there's questions about, well, if I have a large capital gain. Let's say I sell a piece of property, but not, you know, my non residence property and I have a several $100,000 gain on it, is that going to push me into a much higher tax bracket? Well, not really because of the way that tax brackets work with capital gains. That income from your capital gains always comes on last.

 

So let's look at an example of how that would work. OK, let's look at another scenario for Jerry and Ginny. And in this time, they've both claimed their Social Security benefits and they've got good benefits. They've got a total of $86,000 coming in. They've also got $60,000 already in long-term capital gains. That's their only income for the year. If we scroll down a little bit, we'll see that their total taxable income is only about $33,000. A good portion of that is because their Social Security is only partially taxable. And all of their capital gains is coming in at the 0% tax rate. So if we look down here, we'll see that they are just under the threshold where they would start paying 15% on their capital gains. So they may look at this and say, geez, we got plenty of room to grab some more capital gains. So they take $10,000 in long-term capital gains right at the end of the year.

 

OK, so they've realized $10,000 more of capital gains and they go to do their taxes and they've got this big surprise here. How on earth did we go from owing $3,500 in taxes to $7,100 in taxes when we thought we were

going to get a bunch of capital gains for free?

 

All right. Let's take a look and see what happened here. So yeah, we only added $10,000, but there's about $18,000, $18,500 to be exact, more of capital gains all at 15%. How did that happen? And we also have in our ordinary income. We've got it looks like about $8,500 more of taxable income. So what happened, not only did we have our $10,000 all at 15% tax, but we also pushed $8,500, or 85% of $10,000 more of our Social Security to go from being non-taxable to being taxable and we can see that right here. So here it was before. And then here it is after.

 

So, this is a form of triple taxation where we had won the long-term capital gains of the $10,000 tax to 15%. Two, we had an extra $8,500 of Social Security go from being non taxed to becoming taxable, so we have to pay tax on that $8,500 and then three that $8,500. Actually pushed up an extra $8,500 of our capital gains to be from that 0% tax bracket to the 15% tax bracket.

So all in all, we end up with an effective tax rate of about 30 little over 36 percent, 36 1/2% on what Jerry and Ginny thought was going to be 0%. OK. So as you could see, there are a few major caveats that we want to be aware of when we decide whether or not it makes sense to harvest capital gains.

 

First one, as we just said, we want to be aware of potential double or even triple taxation. We need to be aware of state taxation. So we've been talking a lot about the 0% Federal Capital gains tax bracket. But every state is going to treat capital gains differently, and a lot of states will just consider it like ordinary income for state tax purposes. Third, if you are part of a Health Care Marketplace plan, you need to be aware of how capital gains may affect your ability to get subsidies and the size of those subsidies.

 

And speaking of healthcare, if you are on Medicare, you also need to be

aware of how capital gains can impact your Medicare IRMAA thresholds for paying higher premiums on Medicare.

 

If you have questions for me, let me know. Come visit me at www.retirementtheory. com or send me an e-mail at mike@retirementtheory.com.